Not an EM-ergency
August 19, 2016
By Ahmed Kamil, W’18 and C’18
Most analysts have attributed EM resiliency to limited trade and financial linkages with the EU and the UK, but also to more benign macro fundamentals, accommodative central bank policy, and less concern about the volatility of capital outflows out of China. As such, market participants have increasingly emphasized differentiated price reaction across EM. We analyze the impact of the referendum on EM currencies and equities in turn.
While the referendum outcome was surprising, EM currencies weakened sharply in line with most “Leave” outcome scenarios. Europe, Middle East, and Africa (EMEA) EM currencies exhibited the steepest declines, as relatively larger remittances and trade linkages exposed them the most to “Brexit” risks. The South African rand and Polish zloty experienced overnight dips of 7% and 4%, respectively, and have since trimmed losses only modestly. Latin American currencies also experienced pressure, with the Colombian peso and the Mexican peso posting respective losses of 3.6% and 3.2% since the vote. Emerging Asia currencies exhibited the least reaction, with the worst performing currencies in the region, the Korean won and Philippine peso, depreciating only 1.3% each against the dollar. Despite sharp declines, most EM currencies retraced losses in the week following the referendum as market participants realized that a UK exit from the EU may not constitute the apocalyptic shock that many feared it to be.
Still, some assert that the results of the UK referendum pose more uncertainty and a larger threat to global growth than last year’s Greece referendum. The fact that EM currency price action one week post-referendum looks comparable to that following last year’s surprise announcement by the Greek government to hold a referendum on an EU bailout package suggests market participants have more faith in the resiliency of today’s EM. Namely, improving EM fundamentals and different global financial conditions have eased worries of contagion.
- Global monetary conditions: Last year, the anticipation of U.S. monetary policy tightening kept EM traders on edge. Today, the aggregate increase of monetary stimulus from major central banks, particularly the diminishing probability of a Fed rate hike in the near term, has quelled fears of capital outflows for EM. Accommodative central bank policy and the growing belief that regulations have successfully prepared financial institutions to react to crises have driven investor differentiation of EMs and has limited downward pressure on EM currencies.
- Domestic conditions: With China shifting focus from rapid growth to ensuring financial stability, Indonesia using fiscal policy to spur growth, and India reforming monetary policy, some note that economic fundamentals in emerging Asia have been improving. Meanwhile, Argentina and Brazilian currencies have strengthened amid optimism that the tide is turning toward market-friendly policies in Latin America.
- Commodities: The price of oil continues to retrace steep losses since 2014 amid global supply rebalancing and outages. Brent crude still remains near $50 a barrel even after the referendum vote ignited concerns about global demand, keeping commodity sensitive currencies – such as the Colombian peso, Russian ruble, and Malaysian ringgit roughly stable.
- Renminbi: Last year, poorly-communicated shifts in China’s FX policy fueled speculation of a one-off devaluation of the renminbi and capital outflow pressures. Given the reliance of EMs on the Chinese economy, sharp moves higher in dollar-renminbi drove outflows across the EM FX complex. Since the UK referendum, the renminbi has depreciated over 1.5% against the dollar without alarming the global investment community. This calm reaction is largely attributed to the improved credibility of the PBoC’s FX regime, helped in large part by enhanced communication from policymakers, as well as traders’ growing familiarity with the PBoC’s relatively new currency basket. Amid this backdrop, market participants note capital outflow pressures have eased.
In the wake of the Brexit vote, EM equity markets also experienced sharp declines but have remained resilient, as the implications of a UK exit from the EU are not expected to have a lasting impact on EM equities as a whole. A closely-watched EM equity index posted a loss of 3.9%, while South African and Polish benchmarks exhibited the weakest performance by a significant margin, dropping 6.9% and 6.3%, respectively. This can be at least partially attributed to their relatively higher corporate sales exposure to European markets at 14% and 8%, respectively, compared with the 5% exposure of EM equities as a whole.
The relative lack of exposure of emerging-Asia to EU and UK markets may also help to explain the comparatively strong performance of Indonesian and Philippine equity indices. This adds to the tailwind of comparatively higher growth prospects, with GDP growth forecasts for 2016 an enviable 4.9% and 6.3%, respectively, compared to 3.4% and 0.3% in Poland and South Africa. Latin American equities have also fared comparatively well, buoyed by a turnaround in Brazilian markets this month. Latin American equities remain the best performing equity market this year.
Historically, EM assets are perceived to be more susceptible to political risk than developed markets, but recent events in Europe have shown this not to be the case. In fact, EM equity inflows outpaced demand for developed markets immediately following the results of the referendum. Despite near-term pressure as a result of increased global uncertainty and diminished risk-appetite, many analysts expect that EM equities will come out of a “Brexit” relatively unscathed, due to relatively low exposure to UK markets and idiosyncratic developments in large EM economies.
Compared to the Greek referendum this time last year, most EM equity indices have outperformed, which is all the more remarkable given the higher perceived severity of a “Brexit” on corporate earnings and investor sentiment than a prospective “Grexit.”
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